EconSouth (First Quarter 2001)


Cover Story

In the dark days of American business in the mid-1970s, few industrialized nations envied the United States for its economy. But in the 1990s the U.S. economy made a dramatic comeback. That’s because, unlike most countries, the United States in the 1980s and 1990s embraced change, recreating the way some businesses operate. While layoffs and plant closings have characterized many industries during this time, this turmoil has resulted in more efficient technologies and production processes. Ultimately, these developments have brought about substantial increases in productivity, incomes and standards of living that have helped reposition the U.S. economy as the envy of the world.

Almost 60 years ago, economist Joseph Schumpeter described how productivity growth in a modern market economy involved restructuring and reallocating economic resources within firms and across businesses, industries and sectors. The phenomenon Schumpeter described is a continuous process of change, sometimes called creative destruction or churning.

Churning is a key feature of the American economy, and in many ways it reflects the American entrepreneurial spirit — the willingness to take risks, to experiment, to adapt to changes, to succeed but also to permit failure.

This process also contributes to the material well-being of society. It is a well-established economic principle that increasing economic productivity over time permits growth in real (inflation-adjusted) incomes of both workers and owners of capital. Churning provides an important mechanism through which productivity grows, but how?

Today’s new entrant firms and plants tend to be more productive on average than new entrants were some years ago. This so-called vintage effect was demonstrated in the 1990s as new firms and plants employed new capital, and this new capital tended to be invested in obtaining the best technology and in developing the best operating practices. These new entrants also provided additional competitive pressure for existing firms. In manufacturing, an estimated one-third of overall productivity growth is accounted for by the exiting of less productive firms and the opening of more productive new plants to replace the old ones.

But existing firms tend to grow in size over time as well. This condition is called the age effect. As a business grows it undertakes additional investment, exploits potential economies of scale and accumulates experience. These factors help to raise a firm’s productivity over time.

Businesses with productivity growth rates that are lower than their competitors’ are more likely to fail and exit the industry. Many firms that fail are recent entrants who tried something new, like a new technology or a new business model that simply didn’t work. But even large, well-established firms fail, perhaps because their size prevents them from adapting to changing economic conditions. Some studies suggest that exiting manufacturing firms tend to be around 20 percent less productive than the average for the sector as a whole.

Being productive
Productivity is an economic term used frequently in both the popular press and academic debates about the economy, but what is it? Productivity is a measure of the efficiency with which the output of a plant, industry, sector or economy is produced. Simply put, productivity is the amount of output per unit of input.

Because labor is the most important input and is relatively easier to measure than other inputs, the most popular measure of productivity is labor productivity, or output per hour of labor input. A broader measure of productivity is total factor productivity, sometimes called multifactor productivity. Total factor productivity is output per generalized unit of input — capital, labor, energy, materials and purchased business services.

Productivity is not simply about working harder. The chart shows that output in the U.S. manufacturing sector has increased during the past decade, but the growth rate for output per hour almost matched the rate of output growth. This development means that overall labor input in manufacturing hardly rose at all over the decade.

Labor Productivity, Output and Hours in the
U.S. Manufacturing Sector
Manufacturing Sector
Source: Seasonally adjusted data from the Bureau of Labor Statistics. Data for 2000 are through the third quarter.

But what causes productivity to increase over time? The answer is anything that can raise the level of output faster than the increase in labor input. For example, consider a bread baker who buys a larger oven that can produce twice as many loaves of bread as the old oven for only a small increase in labor effort. Labor productivity rises because capital spending increases relative to labor. Labor productivity can also increase through a shift in multifactor productivity. For instance, the same baker discovers a yeast variety that causes bread dough to rise faster, allowing more production runs in the day.

How do firm- or plant-level productivity increases affect overall productivity growth? Labor productivity growth can differ widely among industries. In part, this fact reflects different rates of adoption of new technologies in industries and different rates of success with that technology. For the overall economy, productivity declines in one industry can offset growth in another, masking the fact that the aggregate sources of productivity growth can vary across industries. Two industries help to illustrate this point.

Sometimes bigger is better
Chickens are a big agricultural crop in the Southeast. In terms of cash receipts, chicken broilers are the primary agricultural product in Alabama, Georgia and Mississippi and the second-largest agricultural commodity in Tennessee. The food-processing sector is important in the Southeast as well, employing around 175,000 workers, or about 2 percent of nonfarm payroll employment in these four states alone. Not surprisingly, chicken processing represents a large component of the food-processing sector, and this industry has undergone substantial change during the last 30 years.

In the early 1960s few chicken processing plants had more than 400 employees, and the predominant product was whole broiler chickens, according to a recently published study commissioned by the U.S. Bureau of the Census. In contrast, today most poultry processing plants have more than 400 employees and produce a diverse array of products.

The modern chicken processing plant typically operates under an organizational structure in which a single business owns a processing plant (or plants) as well as a feed mill and has a number of growers under contract. The owner typically provides the growers with chicks, feed, veterinary services and other inputs, and the growers contribute housing and the labor services for raising the chicks until they are ready for processing. At that time, the chickens are slaughtered and converted into various raw and semiprocessed, ready-to-cook poultry products that are sold to retailers, wholesalers or buyers in export markets or shipped to processing plants for conversion into luncheon meats and other products.

Beginning in the 1960s, efforts to reduce processing costs associated with converting live chickens into final consumer products led to major changes in the size and scope of plant operations, according to the study. For example, plant owners increased the number of chickens processed and reduced labor costs by using larger-capacity chill baths and automated dressing and deboning equipment. The industry also focused on developing larger and more uniform-sized birds, permitting faster line speeds and more meat per bird with little or no change in labor and capital inputs. As a result, the average poultry plant size has increased dramatically during the last 30 years as average costs have dropped substantially.

These and other innovations have provided consumers with higher-value products as the product mix has shifted from whole birds to boneless and cut-up poultry products. Processed products have also proliferated to include items ranging from patties, nuggets and ground products to whole cooked birds, hot dogs and luncheon meats. The important observation in this industry is that, although the shift in product mix increased labor costs because many more laborers were required, it also resulted in higher-value output.

Sometimes smaller is smarter
Steel production has also been a significant business in parts of the Southeast over the years and moving toward higher-value product mixes has also been important in explaining that industry’s recent revitalization of productivity. In the steel industry, however, this transition has typically been achieved through substantial reductions in average plant size and the introduction of new technologies.

Beginning in the mid-1980s, rapidly changing customer demands and expanding global competition triggered an extensive modernization of the American steel industry. Much of this restructuring involved the shift from integrated mills to minimills and the retooling of many continuing plants. Modern steel mills are a far cry from their behemoth predecessors.

An industry association, Steel Alliance, provides several estimates showing that labor productivity in the steel industry has doubled since 1982 as a result of restructuring. The association estimates that in 1982 one ton of finished steel required over 10 manhours to produce whereas the industry average was just under four manhours by 1997. Mills were likely to employ an average of 7,000 workers in 1980 but only 4,000 workers by 1985. In the United States in 1980, primary metal industries, including the steel industry, employed 1.2 million workers. Today that number is closer to 700,000, but production levels are comparable to those in the early 1980s.

Downsizing of individual plants was associated with large subsequent productivity gains in the steel industry as a whole. In addition, relatively greater use of capital in the steel industry has led to changes in labor productivity at the plant level. Taken together, these developments paint a picture of many plants changing their mix of inputs — labor, capital and business services — in dramatic ways and thus boosting labor productivity for the industry as a whole.

No single model of productivity growth
As the experiences in the chicken and steel industries suggest, plant-level restructuring can yield substantial productivity gains that over time affect an industry’s aggregate productivity. Although it may be easy to understand intuitively how innovations can bring about productivity gains, the links between the reallocation of inputs, outputs and productivity growth are in fact quite complex. For example, plants often change the mix of inputs at the same time they are changing the scale of production. Some technological innovations, like minimills in the steel industry, may lead to substantial downsizing at plants that adopt the new technology.

Alternatively, technological innovations may take the form of cost savings or product quality enhancements that allow the plants that adopt them, like those in the chicken industry, to increase their market share by expanding plant size. In short, there is no single model of productivity growth because the process is a complex one that exhibits considerable diversity across businesses.

Uncertainty probably plays an important role in generating this diversity. Uncertainty about the demand for new products and the cost-effectiveness of new technologies encourages firms to experiment with different goods, technologies and plant designs. Managerial skills and ability are another factor that can differentiate one business’s performance from another’s.

Adjustment costs
Achieving greater long-term economic growth through continually reallocating economic resources involves short-term adjustment costs that shouldn’t be ignored, however. Higher rates of job creation and destruction imply larger numbers of workers shifting between jobs and possibly into and out of unemployment. Some researchers estimate that one in 10 manufacturing jobs disappears over the typical 12-month period while a comparable number of new jobs open up at different manufacturing locations. Most of this activity occurs at plants that are experiencing large employment changes — shutting down or starting up. Indeed, about a quarter of job destruction is the result of plant shutdowns.

Sharp increases in job destruction and a relatively mild slowdown in job creation rates usually characterize slowdowns in the business cycle. The large number of layoffs announced in late 2000 and early 2001 along with the relatively small increase in overall unemployment provides ample evidence that job churning is occurring through the job destruction and creation process.

Looking ahead, it appears that American businesses remain committed to searching for productivity enhancements that will help them stay competitive in existing markets or to creating new products that distinguish their firms from others. And while employees may come and go as firms continually adjust their mix of inputs in their search for greater productivity, ultimately businesses, employees and consumers will reap benefits since greater productivity ultimately translates to greater economic prosperity for everyone.

This article was written by John Robertson, assistant vice president in charge of the Atlanta Fed’s regional research section.

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